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« Deleveraging | Main | Sign of the times »

Mar 15, 2008


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Jason Van Steenwyk

I'm not sure that you can simultaneously eliminate moral hazard and guard against catastrophic financial collapse.

Moral hazard arises when individuals or institutions make risk/reward decisions on the basis of expecting a bailout. Well, if there's a safety net designed to infuse "liquidity" into our stupidest institutions (e.g., the Federal Reserve, Fannie Mae, Freddie Mac, but it could also come in the form of various kinds of insurance or even a rich and kindly uncle), then there is going to be an element of moral hazard creeping into the equation.

We encourage destructive moral hazard with the current mortgage bailout. We encouraged it with the S&L bailout before.

One exception seems to be FDIC insurance, which does seem to encourage conservatism on the part of consumers.

In other circumstances, though, because the individual does not bear the full downside of longevity risk, Annuities, Social Security, and defined benefit pension plans, on the other hand, tend to create perverse incentives for individuals to live longer, healthier lives.

Andy H

The grounds that "a crash threatens the entire system" are not reasonable. Don't bail them out. Let them fail. Life will go on. These companies won't cease to exist. They'll just be bought out for pennies on the dollar. That way the people who will be punished the most will be the ones who neglected to consider risk. Then in the future maybe they'll be accountable for their actions, and accountable to their shareholders.

Jerry M

I believe that the assumption that institutional market players anticipate a bailout is generally in error. The 3 banks that I worked for that failed had no such illusion. They just did not appreciate the extent of the risks they were taking. All 3 (2 mutuals and 1 stock) were liquidated. Incidently, S&L's were not "bailed out"; what was bailed out was a federal agency, the FSLIC (Federal Savings & Loan Insurance Coporation.) They didn't understand the risk either.

Brian Macker

Is it "regulation" or is it "fraud prevention". Why should banks be allowed to collectivize risky loans, slice and dice the result, then sell them to others as AAA bonds? Simple fraud.

Furthermore, there are conflicts of interest involved that stink of fraud. If a company is touting itself as an "independent" assayer of bond risk when in fact it isn't then that's fraudulent too. Same with the way the banks have been taking the uncollectable debt off the book by creating shell corporations where they hide their garbage assets.

This is all about fraud.

One of the other things it became was gambling. The reason why gambling is bad is that it's unproductive activity that only serves the purpose of entertainment and yet one can make the mistake of thinking it's a way to make money.

A bunch of guys playing cards can be fun but if they all do so expecting to live off the earnings then they are decieving themselves. They can't because there is no "earnings" because it isn't a productive activity, and furthermore it distracts them from productive activity. So if they make it a full time "job" then there will be a "net" loss for the group and the winners will be living on the savings of the losers.

Which is all fine as long as they realize with open eyes that it's only entertainment. If at any point any gambler has the mindset that "I'm going to make money" then he is decieving himself. No you are going to "Win the savings of others" because you are not making anything.

If in fact one of the guys in the card game borrows some money off a family member claiming to be "investing" the money then he is fraudulently borrowing that money.

This brings us back to these investment schemes. When you lend money to people who can't afford the payments on their salaries in order to buy houses then you are in fact gambling that the price of housing will go up in the short term. You are in fact pretty much buying the house yourself and defrauding the borrower out of some payments in the meantime. Furthermore, if this is widespread you are gambling that the price of housing will go up based on being able to rent with the very same payments to somebody else.

This is fraud because of a couple factors. Since the borrower taking out the loan can't make the payments over an extended period he will soon have to default. Also since all loan payments are front loaded with interest (not principle) in the early payments the borrower can not possibly gain any equity in the house.

It's entirely possible the person borrowing the money does not realize he can't afford the payments, because of tricky issues like variable rate loans. Especially when the Fed Chairman, Alan Greenspan, is recommending variable rate loans as a smart move. It isn't.

This is not obvious (except to a banker) and can only be learned through experience. Most every person who has learned this stuff has done so via someone else "in the know". So it is highly likely the borrower may not know this. Anyone buying a house without this knowledge and with payments he cannot afford is in fact being duped by the lender.

This kind of fraud wouldn't be that serious to the economy as a whole in an normal lassez faire business environment. It would still be a kind of "stealing from ignorant people", but it wouldn't cause disruptions in the economy.

Now add in the fraud of a fiat money supply, and the government lowering interest rates below market prices, opening free trade with other countries, social security, and those other countries moving to the free market. All these effects have a tendence to cause the clustering of error within our economy. The price signals provided by the market were interfered with in such a way as to make all individuals in the US believe they could make payments they couldn't. We believe that we are "making money" but in fact we are in a big card game "living off the savings of others". THese are in fact non-market forces, and caused by government interference.

Back to the loans. Well the lending institutions got into this game of lending to people who couldn't afford, precisely because the lowered interest rates over a prolonged period was causing asset inflation. The governments interference with the market results in what appears to be rising asset value, for what is in fact just the same old house.

So the lenders began to believe this was a win-win situation and started making these risking loans to more an more people. They believe they can rip off some initial payments which are 100% interest, then repossess the house and sell it for a profit.

Works fine if you just do it to a few ignorant fools but when you start doing it wholesale it becomes a ponzi scheme. The reason for this is that the housing prices start to go up because these people are on "the margin economically" and thus effect housing prices more, and the lending itself increases the money supply forcing prices upward.

Prices are determined at the margin if you know your economics. It's the person with the most valuable use for a product that causes the price to go up when he bids more for it. Giving some ignorant slob free access to cash allows him to become this margin buyer. He thinks he has a more valuable use for the house than the market had previously determined, his living in the house. However that is not the case. The market was right before because he couldn't afford it and the prior lower asset price was the correct price.

The value of products is also determined by the ratio of money to goods. The ratio sends a signal as to how much goods of each kind to produce. This is automatic and does not require government intervention to occur. However if the government steps in an sets price floors then producers will over produce. In this case a kind of price floor in housing has been created by low interest rates. It's not a de jure (by law) but a (de facto) one caused by the artificially low interest rates.

The de facto aspects of price floors must occur even in cases of de jure floors because the government does not have the power to violate economic law. If the government wants to raise the price of oranges it can do so de jure and make a law to that effect but then the marginal consumers are going to stop buying it at the higher price. The goverment must then step in and de facto buy up the excess oranges. It then has to do something with the oranges. If it gives them away that will cause the price to drop on the market. So it must destroy them. This it does, and this has occurred in our country.

Another way to de facto lower the floor is to subsidize the transaction of "buying oranges". The government takes money away from taxpayers and pays a subsidy to either the consumer of the oranges, the producer, or some combination.

With housing the price floor is created by the goverment subsidizing the consumer via below market interest rates. So that is why it causes a price rise. The consumer can't actually afford the product at these prices.

So the entire effect of this and the other factors is to drive the housing prices up, as more an more people become home owners. Another effect like with the oranges is overproduction by producers. There are now more orange trees than the consumer actually needs, or in this case more housing, more contractors, more real estate agents, more loan officers, etc. The economy is totally distorted being fat in housing.

The house price settled on by the free market was correct given the amount of cash and number of houses. Now however with monetary inflation (not price inflation) not only is the price skewed upward but producers have produced additional units of housing which would tend to lower the prices of houses in a free market. The gap is increased by this. So on the free market your house may be actually worth a lot less that it started at if the government were to allow the credit bubble to contract the money supply back to old levels.

It's impossible to know the true market prices of housing in this environment. Many people who borrowed to buy houses at prices that looked affordable really could not afford the houses in the first place. They have jobs that were created in an inflationary period that will evaporate. Jobs in construction, real estate, etc. Plus jobs further up the chain. Water tank manufactures, nail manufacturers, etc. This is what the austrian economist refer to as distortion.

So the true market prices of many goods are distorted too. Leading producers to overproduce in other areas.

Back to these lenders who think they can rip off marginal borrowers by preying on their ignorance. That is, get a couple of payments of pure interest, then if the borrower defaults, repossess the house and sell it at a profit. Well this all depended on rising prices, and those prices were rising in part because of the very kind of risky borrowing to begin with.

It was also based on these people actually living in the house. The bank is making a pure gamble because it has no productive use for the house. The bank executives can't live in all the houses produced. So this whole scheme, like a ponzi scheme, eventually runs out of marginal borrowers. The process consumes the "suckers" until there are no more. Who is left holding the bag at this point? Well the suckers are out their payments, and the banks are left holding the assets they gambled would continue to appreciate.

Problem is that not only can't they appreciate but they must fall because the very people that couldn't afford the payments are the ones they must rent to. There are no other buyers at this point so they must depend on renters. The only new renters are these ignorant slobs who couldn't afford the payments. Not only that but there are now even more houses.

They are not in the situation anymore where they are dealing with a few suckers they can walk away from. They are dealing with suckers that they are joined at the hip to.

The banks hold the bag. Well not really. The banks have no money of their own really. They are holding the savings of others backed by government guarentees. So the bag holders are the tax payer and the saver. The proportion of pain will be determined by the government to a certain extent but it's not completely in control.

If it screws the taxpayer by indemnifying the accounts held by banks that to under well that's extremely inflationary, and will tend to make the cash returned to the account holders worth less than what it was when deposited. In certain cases the governments hands are tied. For instance, all federally insured savings accounts up to what used to be $100,000 will have to be indemnified. The taxpayer must pay for these.

The government could of course not bail any one of the other types of savers out. Like money market holders, uninsured pensions, corporate cash holdings, etc. These include investors in real estate backed bonds. If the government doesn't then the opposite will occur, monetary contraction. Which will cause an horrible recession.

We are screwed.

Now there is one thing to take note of. Many of the people who could potentially be screwed are foreigners, and they don't vote. Foreigners are holding lots of bonds and cash. Inflation will do the most to screw them over in proportion to screwing over the US citizen. So there will be enormous political pressure to do this. Again, citizens will suffer regardless because inflation hits all.

So I predict unprecidented inflation, and many others are of this belief too as shown by the increase in the price of silver and gold. There are many other economic indicators showing I am correct about this like the trade deficit, low savings rate, etc.

So basically what we have here is not "deregulation" so much as the government openly allowing fraudulent transactions to occur while at the same time overheating the economy via the additional fraud of fiat monetary expansion. If you wish to call that "deregulation" then perhaps you should call removing laws against nigerian scams, and other con artist games, "deregulation".

The kind of regulation that free market people are against are those that allow producers to exclude competitors and raise prices, not laws that protect those who are ignorant from being preyed upon by the well informed. So we, at least the most intelligent of we, do not consider this deregulation. This was out and out legalization of what should be illegal activities.

The government has basically set things up so that the fat cats can bet with taxpayer money and if they win walk away with the proceeds and if they lose well, tough luck taxpayer.


Repealing Glass-Steagal may someday be viewed as the most catastrophic mistake of our generation.

Conflict of interest is not why, however. Most everyone has forgotten the primary reason why Glass-Steagal was so important: it separated banks, insurers, and businesses so that a failure in one area could not cascade into a Panic and collapse the entire economy.

After most of a century, people are once again assuming a systemic collapse is impossible, even as they remove the mechanisms that prevented it for so long.

It's an unnecessary gamble. Pray we never pay the price.

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